What is a prepayment penalty?

A prepayment penalty is a fee that borrowers may incur if they pay off their loan early, in whole or in part, before the agreed-upon term ends. This fee is typically included in the loan agreement to compensate the lender for the loss of interest income that would have been earned had the borrower continued to make payments as scheduled. Lenders may impose this penalty to discourage early repayment, ensuring that they receive their expected returns over the life of the loan.

This concept is especially relevant in the context of fixed-rate mortgages, where the lender has calculated interest revenue based on a longer repayment period. If the borrower repays the loan early, the lender may not only lose the scheduled interest payments but also face costs related to lending that money elsewhere. Therefore, a prepayment penalty protects the lender's financial interests while potentially impacting a borrower's financial decision-making.

The other options pertain to different financial scenarios that do not relate directly to the act of paying off a loan early. Late mortgage payments incur fees as penalties for missed deadlines, while costs associated with refinancing relate to changing the terms of an existing loan, not the repayment of the loan itself. Similarly, penalties for loan default are consequences of failing to repay the loan as agreed, which differs fundamentally from